[D&T] Economic Outlooks Q1 2014 China

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China: Stepping into the unknown

Global Economic Outlook, Q1 2014

China’s government recently announced ambitious plans that could make the Chinese economy more market driven, consumer driven, transparent, and prone to profitable investing. Implementation remains a significant challenge, but it is crucial to rectifying the country’s currently unbalanced system.

“It’s about cutting power, it’s a self-imposed revolution. It will be very painful and even feel like cutting one’s wrist.”

— Premier Li Keqiang speaking in March 2013 on what reform will entail[1]

China’s leaders have finally provided some details about the nature of the reforms they intend to implement. They haven’t said when or how these reforms will take place, nor is it known to which degree Chinese leaders will generate the internal support necessary for the reforms. But what we do know is that the plans are ambitious and, if fully undertaken, could lead to a very different Chinese economy. China could become more market driven, consumer driven, transparent, and prone to investing in projects with a positive return. This is all for the better. The real question, however, is whether China can implement its plans in time to avoid the problems that might arise from the currently unbalanced system.

For now, China’s economy is growing relatively slowly compared to the past. Too much of its growth is coming from factors that contribute to imbalances and set the stage for future problems, such as fixed asset investment, especially in construction. Conversely, not enough growth is coming from factors that ought to be sustained in the long run, such as consumer spending. Additionally, the critical export sector is providing mixed signals. However, a recent purchasing manager’s index suggested a slowdown in exports[2].

Reform intentions

The reform program proposed by the Chinese government is radical yet cautious. It proposes increased competition for state-owned enterprises (SOEs), yet fails to propose privatization of SOEs. It proposes the protection of private property rights, yet fails to give up state ownership of land. It does much to decentralize economic power by empowering the private sector, yet it pulls more power into the hands of the central government, often at the expense of local and regional governments. As such, it is a mixed bag of reforms.

Despite this ambiguity, it is clear what the government generally hopes to achieve. The reforms, if implemented successfully, should lead to faster economic growth, less financial risk to the economy, and a shift in growth away from investment in fixed assets. In addition, the reforms tackle a variety of social issues—promoting more income equality as well as a more powerful and less corrupt judiciary. Finally, the reforms are somewhat conservative in that they aim to stabilize the economy and society by engendering greater predictability. There should be more transparency of financial markets and SOE finances, more professional management of SOEs, less reliance on the decisions of fickle local officials, and more reliance on market forces to determine the allocation of resources.

As to the potential impact of the reforms, this depends on how fast and the degree to which they are implemented. Many reforms will only bear fruit over a relatively long period of time. Reform of the financial system, on the other hand, might have more immediate implications for the functioning of financial markets. Given the problems in the banking system that have already been discussed in past editions of this publication, the faster China improves the efficiency of its financial services industry, the better.

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The reforms, if implemented successfully, should lead to faster economic growth, less financial risk to the economy, and a shift in growth away from investment in fixed assets.

Reform detailsHere are some details released by the government:

China will change the government’s relationship with SOEs. Going forward, SOEs will be required to return 30 percent of their profits to the government. Currently, they return between 0 and 15 percent. The added income to the government will be used to fund improvements in public services. Moreover, some state-owned capital will be transferred to state-run pension plans. All of this is meant to partially address the issue of income inequality. In addition, China will allow private investors to take equity stakes in projects funded by SOEs. This will create more of a mixed economy, one not as dominated by SOEs. However, the government did not discuss further privatization of SOEs—although this could come later.

Meanwhile, the government said that it wants to introduce more competition to break up the monopolist practices of SOEs. Some SOEs will be broken up in order to create competition. Others that are natural monopolies will be more closely monitored by the government, with government responsibilities separated from commercial responsibilities. In addition, the government will encourage hiring of professional managers from outside SOEs to run these enterprises, rather than relying on Communist Party officials. The idea is to engender professional management. Finally, the government pledged to “strengthen SOEs’ investment accountability and explore ways to publicize important information.”

The government will try to promote a more competitive market with market-determined prices. Specifically, the government said that “any price that can be affected by the market must be left to the market. Areas in which the government sets prices will be confined to public utilities, public service, and areas that are naturally monopolized.” In addition, the government pledged to “erase regional protection, illegitimate favorable policies, and monopoly.” It will “perfect the market exit mechanism to promote the survival of the fittest.[1]” In other words, businesses will be permitted to fail. It is not clear if this includes state-owned businesses.

China will allow private investors to establish commercial banks in competition with state-run banks. In addition, the government will “build a deposit insurance system and complete the market-based exit system for financial institutions.[2]” These actions could potentially create a more competitive market for bank deposits and commercial lending. Deposit insurance will set the stage for easing control of deposit interest rates and allow banks to fail or shrink without substantial risk to depositors. Still, more financial market reforms will be needed to curtail the risks associated with the financial system.

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China will promote the protection of private property. It said that “farmers will be given more property rights” and that they should have the “right of succession.” Moreover, a “rural property rights trading market will be established.” This means that farmers will be able to bequeath or sell their land rights. As such, they will have an incentive to invest in boosting farm productivity. The results should be higher food production, lower food prices, greater farm productivity, more rural-urban migration, and less income inequality. Beyond the rights of farmers, the government said “the property rights of the public economy are inviolable, as are the property rights of the non-public economy. The government protects the property rights and legitimate interests of all kinds of ownership by ensuring that various ownerships have equal access to production factors, open and fair market competition, and the same legal protection and supervision.[1]” Thus, while there is no talk about further privatization of state-owned assets, there is implicit recognition that the rights of private property owners must be protected.

China will relax the system of residency permits known as the hukou system. Rural residents will be free to migrate to small and medium-sized towns and have access to public services in such towns (unlike the current situation in which migrants are treated as second-class citizens without access to services). However, restrictions on migration to megacities will remain. Evidently, the leadership wants to encourage rural-urban migration, but not to the biggest cities. This means that labor shortages in big cities may persist. In addition, by providing public services to migrants in other cities, the government is implicitly pledging to boost spending on such services. As discussed earlier, taxing the profits of SOEs will be intended to fund such services.

The government pledged to establish a special court to handle disputes concerning intellectual property. While it is too early to know how serious this pledge is, it suggests a desire to deal with this festering issue. The statement specifically alluded to an intention to stimulate innovation. Without protection of intellectual property, innovation will clearly stagnate.

The government will change the one-child policy. Currently, if neither spouse in a married couple has siblings, the couple is permitted to have more than one child. Going forward, they will be permitted more than one child if only one parent is an only child. This is clearly aimed at correcting the labor shortage that the old policy created. However, it will take another generation to have a real impact.

The government will address problems in the health care system. Specifically, it will “encourage private investment in the medical sector and prioritize supporting nonprofit hospitals run by private investors.[2]”

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Currency reform

One of the notable areas for reform not covered in the government’s statement relates to the currency. However, the government has separately addressed this issue in recent weeks. Indeed, China’s government continues to set the stage for eventual flotation of the currency. For years, the central bank has purchased foreign currency reserves in order to suppress the value of the renminbi, thereby maintaining the competitiveness of Chinese exports. The deputy governor of the People’s Bank of China (PBOC) recently said that “it is no longer in China’s favor to accumulate foreign-exchange reserves.” He said, “We will increase the role of market exchange rates, and the central bank will basically exit from normal foreign-exchange market intervention.[1]” He also said that appreciation of the currency would benefit more people than it hurts. He is right. After years of currency market intervention, China has accumulated $3.6 trillion in reserves. One way to look at this is to say that China has sold $3.6 trillion in apparel and electronics to US consumers in exchange for US government securities, the value of which is bound to decrease. While this has kept Chinese workers employed, it has hurt Chinese consumer purchasing power and caused a substantial distortion of the Chinese economy. The fact that the government is now willing to address this issue is good news.

If China stops intervening, the currency will rise in value, boosting consumer spending, suppressing inflation, and helping China shift toward a consumer-driven economy. For the rest of the world, a higher-valued renminbi means that exports to China will be more competitive. Still, the PBOC gave no indication about the timing of a shift in policy. Meanwhile, it is likely that speculative capital will flow into China in anticipation of this policy shift. Until the new policy is implemented, this could mean even more currency intervention will have to take place to avoid currency appreciation.

All of this is highly significant because it moves China closer to its ultimate goal of making the renminbi a convertible currency that is widely traded and used as a global asset. Yet exchange rate flexibility is only one part of this move. The deputy governor of the central bank also said that the bank will no longer restrict the volume of foreign investment[1]. It will also gradually end caps on deposit interest rates. The latter would be the most significant action because it would go a long way toward fixing what is wrong with the banking system. However, no time frame was given for the latter reform, and so a degree of uncertainty remains. Still, it is clear that the leadership intends to move the country in a far more market-oriented direction.